Term
| What are the factors that affect an option's price? |
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Definition
1 - current stock price
2 - strike price of the option
3 - time to expiration of the option
4 - r - short term interest rate
5 - D - present value of the divident of hte underlying stock
6 - expected volatility of stock prices over time
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Term
| Learn the upper and lower bounds for calls and puts (see page 105 of book 2 for answers) |
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Definition
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Term
| Define a bull call spread |
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Definition
buyer of the spread purchase a call option with a low exercise price and subsidises the purchase price of the call by selling a call with a higher exercise price.
the buyer of a bull spread expects the stock price to rise and the purchased call to finish in teh money. However he does not believe the price of the stock will rise above the exercise price for the written call. |
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Term
| How is a protective put constructed? |
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Definition
| by holding a long position in the underlying security and buying a put option. Limits downside risk at the cost of the put premium |
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Term
| whats a bear call spread? |
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Definition
it's the sale of a bull call spread. the bear spread trader will purchase the call with the higher exercise price and sell the call with the lower exercise price.
Designed to profit from falling stock prices.
The long call is to protect from sharp increases in the stock priec. |
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Term
| What does a butterfly spread involve? |
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Definition
the purchase or sale of three different call options:
investor buys one call with a low exercise price, buys another call with a high exercise price, and sells two calls with an exercise price in between.
the buyer is betting the the price will stay near the strike price of the written calls.
Loss is limited. |
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Term
| How do you create a calender spread? |
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Definition
created by transacting in two options that have different expirations.
eg - selling short dated option and buying long dated option. both with same strike price. |
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Term
| how do diagonal spreads differ from calender spreads? |
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Definition
| diagonal spreads can have different strike prices in addition to different expirations. |
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Term
| How do you create a long straddle? |
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Definition
a long straddle (aka botom straddle or straddle purchase) is created by purcahsing a call and a put with the same strike and expiration.
It profits with strong price moves in either direction, thus it bets on volatility. |
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Term
| What does a short straddle do? |
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Definition
| sells both options and bets on little movement in the stock (bets as per caledner spread or butterfly spread) although in a short straddle losses are not limited. |
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Term
| How does a strangle differ from a straddle? |
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Definition
In a strangle the purcahsed option is slightly out of the money so it is cheaper to implement than the stradle.
Because it is cheaper the stock price will have to move more relative to the straddle before the strangle pays off. |
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Term
| What does a strip involve? |
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Definition
purchasing two puts and one call with the same strike price and expiraton.
It bets on volatility and wins either ways with strong price moves but pays off more on the downside. |
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Term
| What does a strap involve? |
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Definition
| 2 calls and one put with same strike and volatility. |
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Term
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Definition
| combination of a protective put and covered call. Usual goal is for the owner of the asset to buy a protective put and then sella c all to pay for the put. if the premiums of teh two are equal it is called a zero-cost collar. |
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Term
| Describe put call parity: |
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Definition
put-call parity holds that portfolios with identical payoffs mucst sell for the same price to prevent arbitrage. Put-call parity is expressed as:
c + Xe-rT = p + S0
note: Xe-rT is a bond that pays strike at maturity. |
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Term
Can it be optimal to exercise an american call option early?
what about an american put option? |
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Definition
Never optimal to exercise an american call option early (on a non-dividend paying stock)
American puts are optimally exercised early if they are sufficiently in the money. The payoff (X - S0) can be invested to earn interest. |
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